Live Big® Digest – Independence Day ed

Live Big® Digest – Independence Day ed

With the July 4th weekend upon us, it’s hard not to reflect on the qualities that have made the US unique and powered its path to prominence (when not thinking about baseball, barbeques, and fireworks, that is).  Of course,  many these days are taking the position that this country’s amazing 235 year run is at an end.  Some point to the “China Model” and say that free markets and a consumer-led system may not be the best way to grow a 21st Century economy.

To that, we say: not so fast.

Some miracles have mundane explanations and the example of Chinese economic development is no exception.  It rarely pays to extrapolate the trends of the recent past endlessly into the future, and it never pays to count the US out of the game based on a few bumps in the road (and, yes, we would argue that current economic conditions in the US are more bump than “New Normal”).  But let’s get back to that Chinese miracle . . .

The China Syndrome
China has just released its latest 5-year plan and, although the government is careful to avoid all references to “the China model,” there is still, as the Economist noted on June 25, plenty of “chest-thumping” taking place.

“What is great about socialism, crowed the prime minister, Wen Jiabao, in March last year, is that it enables China ‘to make decisions efficiently, organise effectively and concentrate resources to accomplish large undertakings.’ In the eyes of some Chinese, and even some foreigners, authoritarianism has gained a new legitmacy.”

While it’s true that the growth rate of the Chinese economy has averaged  10% since 1980, compared to less than 3% for the US, it would be a mistake to extrapolate that too far into the future.  First of all, developing economies start from a low base, making extremely high growth rates common in the early years.  Japan, for example, built a modern economy out of the ashes of World War II, attaining a 10% average annual growth in GDP by the 1960s.  By the seventies, however, that average had fallen to 5%, continuing to slide to 4% in the eighties, and 1.8% in the nineties.

It’s also worth noting that one of the drivers of growth in developing economies is the movement of unemployed/underemployed rural populations into the industrial centers, providing cheap labor to manufacturers.  With a population in excess of 1 billion, mostly in rural regions, China had a particularly deep pool from which to draw at the beginning of its industrialization. That dynamic is shifting, however, and as the pool shrinks and consumer prices soar, China has seen suicide rates and wage demands in the industrial cities soar as well.  The end is in sight for the age of cheap labor in China.

When it comes to grand predictions, it’s instructive to remember the seemingly endless stream of news stories and books in the late 1980s and early 1990s trumpeting the ascension of Japan.  It was widely assumed that the Japanese economy would soon eclipse America’s as the world’s largest.  Not only did that not happen, but the US economy today is three times larger than Japan’s.

The International Monetary Fund (IMF) recently predicted that China’s economy would surpass America’s by 2016, while the Economist magazine, using a different measure, has predicted that this will happen by 2020.  We’re not so sure.  Here’s economist Nouriel Roubini’s take on “China’s Bad Growth Bet”:

“China has grown for the last few decades on the back of export-led industrialization and a weak currency, which have resulted in high corporate and household savings rates and reliance on net exports and fixed investment (infrastructure, real estate, and industrial capacity for import-competing and export sectors). When net exports collapsed in 2008-2009 from 11% of GDP to 5%, China’s leader reacted by further increasing the fixed-investment share of GDP from 42% to 47%.

The problem, of course, is that no country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem. China is rife with overinvestment in physical capital, infrastructure, and property. To a visitor, this is evident in sleek but empty airports and bullet trains (which will reduce the need for the 45 planned airports), highways to nowhere, thousands of colossal new central and provincial government buildings, ghost towns, and brand-new aluminum smelters kept closed to prevent global prices from plunging.

Eventually, most likely after 2013, China will suffer a hard landing. All historical episodes of excessive investment – including East Asia in the 1990’s – have ended with a financial crisis and/or a long period of slow growth. To avoid this fate, China needs to save less, reduce fixed investment, cut net exports as a share of GDP, and boost the share of consumption.

The trouble is that the reasons the Chinese save so much and consume so little are structural. It will take two decades of reforms to change the incentive to overinvest.”

One final point to consider is that the gross size of an economy is not in any way a measure of relative affluence.  That’s to be found in the GDP per capita numbers.  China’s current GDP per capita is $4,382 versus $47,284 for the US (source: IMF).  Whatever the size of the economy as a whole, it will be a long time, if ever, before the “China model” delivers the same level of affluence to its citizens that the “free market model” has delivered to ours.

The Big Short
John Paulson, the hedge fund manager profiled in Michael Lewis’ book “The Big Short,” has proven once again the limits of prediciton.

Paulson became famous for profiting from a huge bet made against the housing market ahead of the 2008-2009 global meltdown, making him the poster boy for those who believe that the future is fundamentally knowable if you but know how to look.

Of course, we believe it’s far more prudent to focus on the limits to prescience and, as reported in the Wall Street Journal, Paulson’s recent experience is a case in point.

In addition to recent losses from large bets on financial stocks, one of Paulson’s investment funds suffered a $500 million “paper loss” from its investment in Sino-Forest, a Chinese timber company.  The company’s shares have fallen 80% since late May amid allegations of questionable accounting practices.  Proving yet again that anyone can come home from Las Vegas a winner, just don’t count on doing it every time, let alone most of the time.

The other lesson here is that financial reporting practices in China, whether by individual companies or government agencies, remain highly suspect.  One more reason to temper our “irrational exuberance” over the Chinese miracle.

Here’s wishing you and yours a restful and happy Independence Day weekend!

The Yeske Buie Team

Dave Yeske